Primer

By John M. BerryBy John M. BerryMarch 2, 1986

In congressional testimony over the past two weeks, Federal Reserve Chairman Paul A. Volcker expressed serious concern about the sharp drop in the value of the U.S. dollar compared with a number of foreign currencies.

At the same time, Treasury Secretary James A. Baker III, Commerce Secretary Malcolm Baldrige and other Reagan administration officials were telling some of the same committees that the dollar must come down further to make American producers more competitive in U.S. and world markets.

There is a difference of opinion between Volcker and the group of officials, but it is not over the appropriate level for the value of the dollar.

The disagreement is over the speed of its decline and whether that poses a risk for the American economy.

The basis for Volcker's concern is that the United States this year probably will need to persuade foreigners to invest or lend upwards of $125 billion more in this country in 1986 than Americans will be investing and lending abroad.

The money is needed to finance the U.S. shortfall in its current transactions with the rest of the world, including a huge merchandise trade deficit that hit $16.5 billion in the month of January alone. In effect, the United States is borrowing this money in order to buy foreign goods.

In the very short run, no conceivable change in the value of the dollar could reduce the trade deficit -- by making imports more expensive and less desirable while exports become cheaper and easier to sell in other countries -- to the point that this large infusion of foreign money would not be needed.

So long as foreigners are easily persuaded to invest their money in the United States, as has been the case for several years, there is no problem.

But when a foreigner exchanges his currency for dollars to invest here, he not only must accept the risk implicit in the investment itself, but an exchange-rate risk as well.

For instance, a Japanese investor who acquired dollars six months ago has seen the value of that investment fall, in terms of the yen, by nearly 25 percent. Each dollar back then was worth about 237 yen; each dollar today is worth only about 181 yen. If the money had been placed in, say, a bank certificate of deposit paying 10 percent, the investor would have had a net loss of 20 percent of the value of his principal. (That is, 25 percent currency loss offset by a 10 percent rate of return for six months.)

Had the investor kept his money in Japan for this six months and earned even 5 percent on it, he still would have his full principal plus 2.5 percent.

Volcker is worried that, sooner or later, a lot of Japanese and European investors are going to do this simple arithmetic and decide, perhaps only temporarily, to keep their money at home.

If that happens, attracting the foreign cash the United States must have would mean raising interest rates until the investors were persuaded again to part with their money.

The Fed chairman told Congress that the real danger is a shift in market psychology that could lead to a desire to get out of dollars. If enough market participants decide to do that, the value of the dollar could go into a sort of free fall. At that point, interest rates probably would soar and inflationary pressures surely would mount.

Volcker was by no means saying that the dollar had come down enough to generate a major improvement in the nation's trade balance. "I would be concerned about too much emphasis on the value of the dollar as a cure for our trade problems," he said.

By that, Volcker was cautioning that trying to drive down the dollar to fix the trade deficit could tip market psychology over the edge. Implicit in that remark was the belief the chairman is known to hold that the decline of the dollar to date will not result in a significant improvement in the trade deficit.

For whatever reason, the big decline of the dollar compared with the Japanese yen and the West German mark seems not to have changed market psychology significantly. However, there are some reports that European investors are moving less money to this country because of the exchange-rate risk.

Meanwhile, investment yields have been dropping, too. Again, to the surprise of many financial analysts this seems to have made little difference to Japanese investors -- many of which are entities such as insurance companies and pension funds with long-term investment goals.

Volcker, as chairman of the nation's central bank, would have to cope directly with the problem of surging interest rates if his fears about market psychology were realized. Baker and Baldrige already are having to cope with the specific effects of the trade deficit on American industry.

Those perspectives led to a different emphasis on what is important about the level of the dollar's value right now. But Volcker, like the others, reportedly expects it to continue to come down over time. He just wants the process stretched out to reassure any uneasy foreign investors who are thinking about keeping their money at home.